What Is Indexation in Mutual Funds? Meaning, and Calculation

What is Indexation in Mutual Funds?

Indexation in mutual funds refers to a change in the purchase price of a given investment to consider inflation. It helps in reducing capital gains that are subject to taxation in eligible long-term investments where indexation is permitted, including debt mutual funds purchased before 1 April 2023. When the investment is long-term, the price of purchase under the Cost Inflation Index is indexed, and thus, the taxes payable are reduced. This made certain long-term debt fund investments more tax-efficient under earlier tax rules.

How to Calculate Indexation?

The Cost Inflation Index (CII), notified by the Ministry of Finance, is used to calculate indexation by adjusting the original purchase cost for inflation. Accordingly, the indexed cost is applied to compute long-term capital gains, which helps reduce taxable profit and lower the tax liability on debt funds.

Formula:

Indexed Cost = (CII in the year of sale ÷ CII in the year of purchase) × Purchase Price

The following example applies to investments that qualify for indexation benefits under the tax laws applicable at the time of purchase.

Example:

Assume that an investor invests in units of mutual funds worth ₹10,000 in the financial year 2018-19 and sells them in 2021-22 at ₹15,000. In the absence of indexation, the capital gain that is subject to tax is ₹5,000.

Suppose the Cost Inflation Index is 280 in 2018-19 and 320 in 2021-22.

Indexed Cost = 10,000 × (320 ÷ 280)

= 10,000 × 1.142857

= ₹11,428.57

Taxable gain = ₹15,000 − 11,428.57 = ₹3,571.43

This shows how indexation reduces tax liability.

Key Takeaways

Indexation is significant in improving tax efficiency for eligible long-term mutual fund investments, including certain debt funds purchased before 1 April 2023. Inflation adjustment on purchase cost minimises taxable capital gains and enhances post-tax returns. It aims to tax gains after adjusting the purchase cost for inflation. This renders indexation a very useful attribute to individuals who desire to construct a consistent and economical long duration investment.

Frequently Asked Questions

Who can benefit from indexation in mutual funds?

Indexation is most beneficial for investors whose mutual fund investments qualify as long-term assets under prevailing tax laws. For debt mutual funds, this benefit applies only to units purchased before 1 April 2023.

Does indexation apply to equity mutual funds?

Equity mutual funds are not subject to indexation. The equity funds are taxed under a different structure, under which long-term capital gains are not adjusted to the inflation rate of the purchase cost.

How does indexation reduce tax liability?

Indexation raises the purchase price of an investment by the use of the Cost Inflation Index. An increase in the adjusted costs decreases the amount of capital gain, which accordingly reduces the tax payable on long-term investments.

What Is Indexation in Mutual Funds?